How Changes in the Yield Curve Could Affect Bank Stocks

Wall Street has been preparing for and fighting against this day for years

Wednesday was a big day for bank stocks. It was the day that the “Volcker Rule” — part of the Dodd-Frank financial reforms that ban taxpayer insured banks from making bets with their own money and named for its designer, former Federal Reserve Chairman Paul Volcker — kicked in.

Wall Street banks have been preparing for and fighting against this day for years. Proprietary trading revenues used to make up a huge chunk of earnings for big bank stocks. But since the introduction of the rule, these banks have had to shift their focus from their proprietary trading desks — which have all but disappeared from within the confines of the major banks — to other cash-generating activities.

Net Interest Margin for Bank Stocks

Banks are able to generate revenues from a variety of business activities. They charge fees for credit card transactions and mortgage originations, they charge fees for investment banking and trading services and, perhaps most importantly, they charge higher rates of interest on the loans they issue than those that they pay on the deposits they receive. The difference between these two rates of interest is called net interest margin.

Net interest margin is dependent on the slope of the U.S. Treasury yield curve — a line that plots the current yields of U.S. Treasuries with different maturity dates. You can see the current yield curve (the up-trending red line on the left side of the image) plotted by the “Dynamic Yield Curve” tool from StockCharts.com as point “A” in the chart below. (The S&P 500 is plotted on the right side of the image. Moving the red vertical line on the S&P 500 will tell you what the yield curve looked like on that particular date).

Source: stockcharts.com

Current U.S. Treasury Yield Curve

Currently, the net interest margin (approximated by the green arrow) is still relatively wide because the slope of the yield curve (the distance between the short-term yields on the left side of the chart and the longer-term yields toward the right side of the chart) is still relatively steep.

However, with the Federal Open Market Committee (FOMC) gearing up to raise interest rates, investors are nervous that the yield curve might start to flatten out.

In an ideal scenario for banks and bank stocks, as the FOMC starts to raise short-term rates, long-term rates will also rise. This would give us a yield curve that would look similar to the curve we had back in March of 2005 (represented by point “B” in Figure 2 below).

Source: stockcharts.com

Steep U.S. Treasury Yield Curve

While banks would have to pay higher rates for deposits in this scenario, they would also be able to charge higher rates on their loans, maintaining a strong net interest margin, because of the steepness of the curve.

Of course, bank stocks may not get their ideal scenario. The scenario that keeps bank managers up at night is one wherein the FOMC starts to raise short-term rates and long-term rates fail to rise. If this happens, it would give us a yield curve that would look similar to the curve we had back in July of 2007 (represented by point “C” in Figure 3).

Source: stockcharts.com

Flat U.S. Treasury Yield Curve

A flat yield curve like this would compress net interest margins and pinch profits of bank stocks.

Unfortunately for bank stocks, the net interest margin levels in general have been trending lower for years (see Figure 4).

Net Interest Margin for all U.S. Banks

The tendency for net interest margin levels to spike as the economy comes out of a recession (indicated by the dark gray lines in Figure 4) and then fade as the economy recovers is one of the reasons financial stocks tend to outperform during early stages of the business cycle and under-perform during later stages (see Figure 5).

Sector Rotation Model

Financial stocks are going to be a good barometer for the health of the current market. If we start to see funds like the SPDR S&P Bank ETF (KBE) roll over, it will be a strong signal that we have reached the maturity stage of this bullish uptrend and that a bearish pullback may be on the horizon.

Fortunately, we’re not there yet (see Figure 6).

Daily Chart of SPDR S&P Bank ETF (KBE)

InvestorPlace advisers John Jagerson and S. Wade Hansen, both Chartered Market Technician (CMT) designees, are co-founders of LearningMarkets.com, as well as the co-editors of SlingShot Trader, a trading service designed to help you make options profits by trading the news. Get in on the next SlingShot Trader trade and get 1 free month today by clicking here.